The Two Sides of the Balance Sheet

Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”

This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)

The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.

The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.

One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”

30 responses to “The Two Sides of the Balance Sheet”

Does ANYONE involved in these matters have ANY idea what they are doing? Paulson and Bernanke scared the living heck out of Congress last fall which resulted in the American people becoming terrified and bringing the economy to a halt. How could that have been good for anyone’s balance sheet, let alone their income statement.
The only consistency being displayed–by bank managements, the financial markets and (especially) the government–is in the names of the key players. It is SO reassuring to have had Tim Geithner consistently in important positions as the analysis and remedies have been outlined and discarded.
Wall Street either has something over Obama or something on him. Take your pick.

I think Noam is part of the problem. Attempting to state that “In fact, it ties in with Treasury’s view that the Geithner plan was misunderstood in some quarters from the beginning” is pure BS. The Geithner plan was understood clearly by many including this website. He then writes that participation was down because of equity raises, not that banks didn’t want to show losses or investors were concerned about being lynched when the public finds out how much money they made being subsidized by taxpayers.

That the banks were able to raise capital has at least removed some of the urgency of dealing with the toxic assets.

The PPIP loan program appeared to be DOA when it was announced, however. The banks had hardly written down the value of the loans (as opposed to the securities) at all, such that even with generous levels of FDIC support, banks and investors were unlikely to find common ground:

The conclusion raising common stock is a substitute for selling toxic assets can be found in my solo and joint research at http://ssrn.com/abstract=1336288 and http://ssrn.com/abstract=1321666. I mostly agree with the blog above, but I think preferred stock recapitalizations are a waste of time for attempts to cure solvency problems.

With the dramatic downturn in commercial real estate and concomitant foreclosers in that sector, as well as the continuing foreclosures in the residential market, default on credit cards and car loans caused by the still-climbing unemployment (it has slowed, but is now over 9.6%), the relative toxicity of the “legacy” bank assets is getting progressively weaker. I just don’t believe that things are improving much. The only thing that is propping up banks’ profits at this point is fees earned by “churning” markets (why do you think that the DJ and other averages haven’t lost more? — because these guys have convinced those with money to try to recoop their losses from last fall — this will work for a while, but when their is no real market movement, it will stop, along with the banks profitability).

Banks right now can’t make money “the old fashioned way” because the capital markets are so dead. Even the business community profitability, which is on the uptick because they are all operating at bare bones, is a sort of myth (look at the drop in revenues).

The gaming of the oligarchy continues to try to sponsor “green shoots” which are disappearing as we speak. The idea that this recession will turn this fall is a “fallicy”. Too bad for us.

If it hadn’t been willfull, one would have to think that those responsible for this affair were largely delusional. That the large banks have been kept alive on taxpayer money donated to them by employee politicians and all the while being permitted to pretend with the connivance of these same politicians that their past excesses caused them no real losses is truly monstrous. No such largesse has been dispensed to the defaulting home owner or credit card borrower. Michael Hudson captures the dimensions of this outrageous inequality and other things as well today at CounterPunch:

Until the system that has been used as a backdrop for this corruption has been replaced with one impervious to the cozy, symbiotic relationships of lobbyists and politicians, the notion that we enjoy representative democracy in this country is simply opera buffa.

The section I liked most is the one on oil. I find it amazing that GS has its own refinery in Kansas. I guess when you’re speculating on oil futures there are times when you end up having to really buy the stuff yourself.

This section alone warrants a close read. You will learn (among other amazing things) that there is a 1936 law limiting speculation in the commodity market.

Another excellent essay: Chris Hedges’ “The Truth Alone Will Not Set You Free” on Truthdig:

“The ability of the corporate state to pacify the country by extending credit and providing cheap manufactured goods to the masses is gone. The pernicious idea that democracy lies in the choice between competing brands and the freedom to accumulate vast sums of personal wealth at the expense of others has collapsed. The conflation of freedom with the free market has been exposed as a sham.”

i thought the uncertainty caused by the presence of the toxic assets on the banks’ books was the cause of the freezing up of the loan market.

the toxic assets are still present and toxic but the banks are declaring themselves back in business. is money being borrowed and loaned again? is the housing market for example starting to function again?

Federal (i.e.; taxpayer/printing-press) backstop for any and every piece of bad news coming down the pike has created a tentative sense of stability in the financial markets. Growth (which involves new risk-taking as opposed to simply kicking old risks down the road) will not happen until toxic assets are properly priced and disposed of.

More Ezra Klein?? Should we just stop reading Baseline and switch to Ezra… if you’re just going to monkey him with every other post you make. This blog is becoming the EzraKleinEchoScenario. I don’t get why you are promoting him like this.

To me, the most galling and telling factor in all of this sorry mess is the impotence of the system itself, filetted as it has been by the reptiles that lobby for the banking sector and the whore politicians and administrators that do their bidding. And if it weren’t the bank lobbying sector calling the tune, one could point to similar realities in the foreign policy (AIPAC), healthcare and arms sectors as well. There is no such thing as political democracy in this country, what is offered – and it is offered from the top down – is an illusion. Worse yet, it is irreformable. What remains to Americans interested enough and brave enough to seek change are mass demonstrations and the general strike. Anything less is farce.

From the evidence, nothing persuades more reliably than a period of incarceration behind razor wire followed by a series of public show trials. I’d recommend this course of treatment for the entire political class together with their lobbyist employers, that way they have a chance of offering genuine service. But it would only be after the new constitutional convention that we’d be able to consider the place of the ECO movement. One thing at a time, kindly.

“United Western Bancorp reports sale of mortgaged-backed securities (9.54 +0.09) : United Western Bancorp (UWBK), a Denver-based holding company whose principal subsidiary, United Western Bank (the “Bank”), is a community bank focused on expansion across Colorado’s Front Range market and selected mountain communities, announced that the Bank sold mortgage-backed securities with an unpaid principal balance of $47.3 mln of lower tranche mortgage backed securities secured primarily by “option-adjustable-rate” mortgage loans (the “Option ARM Securities”) to an unaffiliated third party. Total consideration received for the Option ARM Securities was $378,000.”